Wednesday, October 16, 2013

Last January I noted that "one of the biggest things happening on the margin is the decline of the Japanese yen." The Bank of Japan was effectively pressured into a serious relaxation of monetary policy. After being extremely tight for many years—as reflected in zero/negative inflation, a relentless appreciation of the yen against virtually all other currencies, a very weak stock market and a moribund economy—the Bank of Japan has completely reversed course. This has had predictable and impressive results.

The above chart shows just how impressive the increase in Japan's bank reserves has been. Reserves are up 137% in the year ending September.

A genuine easing of monetary policy ought to result in a weaker currency, and that is exactly what has happened in Japan. The yen has gone from 78 to 99 vs. the dollar in the past year, a decline of more than 20%. And to the extent that Japan's weak economy in recent years was the result of deflationary monetary policy, then easier money and a weaker yen ought to result in a stronger equity market. And indeed, as the chart above shows, that is exactly what has happened. Japanese stocks are up over 60% in the past year in yen terms, and up 33% in dollar terms. Japan has apparently succeeded in reflating its deflated economy, and that is a good thing.

Inflation typically responds to changes in monetary policy with a lag, and that is exactly what is happening. As the chart above shows, Japan is now registering inflation of almost 1% in the past year, and it's likely to increase further over the next year. As inflation expectations increase, the desire of the Japanese to hold on to lots of yen declines, and the velocity of money increases, and that fuels faster nominal GDP growth. It's already apparent: inflation has accelerated (albeit only modestly so far), and in the first half of this year, Japan's annualized real GDP growth was almost 4%.

Japan's monetary policy has done a good job. Going forward, the key to real success will be Japan's commitment to genuine fiscal stimulus (e.g., limiting the growth of public sector spending, reducing regulatory burdens, and reducing tax burdens). Prime Minister Abe seems to understand this, but of course the proof will be in the pudding.